Global Economic Outlook

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The Economic Situation for Retailers
The global economy is decelerating, with growth in 2012 likely to be slower than was experienced in 2011 in many of the world’s leading markets.

In Europe, the crisis of the euro has led to the tightening of credit markets. In an effort to rebuild investor confidence, governments across the continent are cutting spending and raising taxes, the net effect of which is to weaken economies and, in the process, further undermine confidence. Meanwhile, the European Central Bank engages in a relatively neutral monetary policy aimed at suppressing inflation. As of this writing, the risk remains that the Eurozone will crumble, leading to an even worse economic downturn.

In the United States there are signs of accelerating economic activity, yet the failure of the government to agree on a path toward fiscal rectitude has wreaked havoc with investor confidence, hurting equity prices and employment creation. While the U.S. economy may accelerate in 2012, it will probably not grow at a pace sufficient to significantly reduce unemployment.

The world’s second-largest economy, China, is slowing following a tightening of monetary policy combined with the negative effects of slow growth in Europe and the United States. In addition, the remaining BRICs face slower growth resulting from the lagged effects of tight monetary policy and weak global growth.

Only in Japan is economic growth in 2012 widely expected to exceed that of 2011. The reason is that 2011 was so awful following the devastating earthquake and tsunami, andreconstruction expenditures are likely to provide a temporary jolt to the Japanese economy.

Retailers may find some silver linings in this otherwise cloudy environment, however. One positive effect of slower global growth will be continued dampening of commodity prices. For retailers, this means some improvement on the cost side of the ledger. Meanwhile, a number of countries, including the United States, Japan, several in Western Europe and many leading emerging markets, are seeing higher retail price inflation. Combined with stagnant input prices, this suggests the possibility of improved profit margins, even in the context of slow top line growth.

In many of the slowing markets, a disproportionate share of the growth of consumer income is accruing to the relatively affluent. This is especially true in the United States and China. Hence, for retailers targeting upscale consumers, the environment might not be so bad. As for retailers targeting everyone else, the ability to offer low prices to uncertain consumers will be a clear competitive advantage.

The most significant silver lining can be found on the long-term horizon. Even though the economic environment in 2012 will be difficult, the long-term outlook for the global economy remains good. Global growth in the coming decade is expected to be strong, with particular strength coming from leading emerging markets other than China. Of course China will grow, but it faces some headwinds, both demographic and structural. Other emerging markets like India, Brazil, Turkey, Indonesia, the Andean region of South America and much of sub-Saharan Africa offer the possibility of stronger growth and new opportunities for the world’s leading retailers.

Let us now consider the outlook for the world’s leading retail markets:

Western Europe
It is difficult to provide a helpful roadmap to a situation that, as of Q4 2011, still seemed to be changing daily. So perhaps it is best to look back at how it came to this.

The Eurozone project was intended to bind the economic and political fortunes of Europe’s economies in perpetuity, yet the architecture of this union was always lacking. Countries were required to maintain fiscal discipline, but there was never a credible vehicle for ensuring it. The first countries to violate the rules were Germany and France, and it is not surprising that others soon followed. Indeed, the existence of the euro enabled the countries of Southern Europe to borrow with abandon. Investors were happy to extend credit at low interest rates with the expectation that bonds denominated in euros were a safe asset.

Still, the absence of fiscal rectitude alone was not the biggest problem. The biggest problem was that several Mediterranean economies lost their competitiveness. Over the past decade, their wages rose far faster than their productivity, with the result that it became less feasible for them to generate the strong export revenues needed to service their external debts. Normally, a country with a competitiveness problem will devalue its currency. However, because these countries no longer have their own currencies, they cannot restore competitiveness unless they dramatically accelerate productivity growth and/or cut wages – both tall orders.

When Greece was unable to roll over its considerable debts and the EU bailout was deemed insufficient to correct Europe’s ailments, investors became fearful. Governments faced difficulty in rolling over debts, and banks that held such debts faced problems raising funds. Risk spreads increased, credit market activity declined and Europe faced a new recession.

Following the summer of 2011, Europe’s governments agreed on various measures to calm markets, but to no avail. Banks agreed to take a haircut on Greek debt, enabling Greece to reduce its borrowing requirement. The banks were then required to raise capital, most likely by reducing lending and selling assets. The EU established a large fund to provide liquidity to troubled sovereign lenders. Intended as a confidence-building measure to assure investors that sovereign debt was safe, the fund failed to calm markets.

There are three possible scenarios as to what might happen next. In the first, Europe agrees to engage in greater integration in order to avoid disintegration. This could entail using the European Central Bank (ECB) to backstop sovereign debtors and create a fiscal union with large transfers of resources from richer to poorer nations within the union. This would enable the Eurozone to succeed and ultimately prosper. The problem with this scenario is that it requires individual countries to give up sovereignty and abide by conditions set by the richer countries in the EU.

The second scenario is that the Eurozone fails. While this could happen, the short-term costs of disintegration would be catastrophic. It can be argued that, in the long run, some of the troubled countries would be better off outside the Eurozone, but much of Europe would suffer grievously during the transition. The Mediterranean countries would face problems in gaining access to global credit markets, while the northern economies would see their currencies rise rapidly, thereby hurting exports.

The third scenario, then, seems to be the most likely: Europe manages to hold the Eurozone together but fails to take action that would guarantee its success. This could be called the “muddling along scenario” and would likely involve a prolonged period of slow economic growth, political turmoil and periodic crises.

What does this scenario mean for retailers? It means continued fiscal contraction across Europe, in part through higher taxes, and tight credit market conditions. Consumer spending would grow slowly, if at all. Consumers would be highly price sensitive and uncertain about the future. For retailers, it would mean a severe market share battle. It would also means that, for retailers that are financially healthy, there would be good reason to accelerate the process of globalization in order to find growth outside of Europe.

China
China’s economy is decelerating, the result of tighter monetary policy in 2011 and declining export growth. In response, China’s central bank has stopped tightening policy. Therefore, although China’s economy will slow in 2012, it will not necessarily slow dramatically. On the other hand, it is notable that a senior Chinese official recently predicted that growth in 2012 would be below 9 percent -- the first year since 2001 that it has done so. Interestingly, there is evidence that the economic slowdown is being experienced principally by small to medium-sized private businesses (especially those that export) and not by the large state-run enterprises that retain favorable access to credit.

China’s officials have complained about the rapid expansion of U.S. government debt. This reflects fear that the massive stock of foreign currency reserves held by China’s government could lose value. Less attention, however, has been paid to the big increase in overall debt in China itself. That is likely to change soon, given the fact that overall debt has nearly tripled in the past five years. Notably, a top Chinese official recently said that the debt of China’s local governments is “our version of the U.S. subprime crisis.” The $1.7 trillion in debts issued by local governments to fund infrastructure has been a concern for some time, but officials have downplayed the danger until now. The fear is that multiple defaults without a bailout from the central government could damage the health of China’s banks. How did this come about?

When the global economic crisis began in 2008 and China’s exports suddenly dropped, the government implemented a vast stimulus program to boost domestic demand and offset the decline in exports. Part of this involved extending credit to provincial and local governments to engage in infrastructure development. In the short run, this policy was successful in boosting growth and preventing a general recession. The problem, however, is that many such investments have failed to generate adequate returns. The Chinese government estimates that little more than one-quarter of local government investment has produced a return adequate to service the debts.

Local government borrowing is not the entire problem. During the global crisis, the government injected capital into state-run banks so that they could lend to state-run companies. The result was an investment boom, but too many of those investments are not producing an adequate return. As a result, investment in fixed assets surged, reaching almost 50 percent of GDP last year. Meanwhile, consumer spending declined to about 35 percent of GDP. Now that the Chinese economy is slowing, the risk exists that China’s debtors will soon face greater difficulties in servicing their debts.

So is China at risk of its own financial crisis? The answer is yes and no. There is a danger that a new round of defaults will damage the solvency of China’s state-run banking system, but it is likely that the government would bail out such banks and, thereby, prevent a larger financial crisis.

China does face a risk, however,. Specifically, if the government were compelled to bail out troubled financial institutions, it would probably not support continued lending for the purpose of poorly conceived investments. Consequently, investment would likely fall considerably. Given that investment is now close to 50 percent of GDP, such a fall could have serious consequences for GDP, absent an offsetting increase in something else. What could that something else be?

Exports are not likely to take up the slack. Instead, China will look toward a boost in consumer spending to offset a decline in investment. Given that consumer spending is now only 35 percent of GDP, it would have to grow very rapidly to make a difference and avoid a significant economic slowdown.

There are, however, some positive signs concerning the prospect for consumer spending. First, wages have been rising, adding to real disposable incomes. This reflects a shortage of labor, as demographic trends limit labor force growth and internal migration slows. In addition, provincial and local governments have been increasing their minimum wage. Second, the government intends to have state-run companies pay higher dividends to shareholders (mainly the government). This money could be used to boost overall spending. Third, high inflation might spur more spending by consumers. Fourth, the currency is gradually being allowed to rise in value. This reduces import prices and helps to stimulate consumer spending.

On the other hand, the biggest negative for consumer spending is simple demographics. Due to the lagged effect of China’s one child policy, the labor force is expected to grow much more slowly in the coming decade than it did during the past 10 years. As such, the prime consuming age cohort will barely grow while the elderly population will grow rapidly.

Finally, one side effect of China’s unbalanced economy is a sharp increase in income inequality. While incomes have increased overall, lower income cohorts have not seen significant increases in purchasing power, especially as home prices have increased dramatically. There are reasons to expect that China’s economy will grow more slowly in the coming decade. Although consumer spending is likely to increase as a share of GDP, it is not clear that it will be sufficient to create a consumer spending boom.

United States
As of this writing, the U.S. economy is showing signs of modest strength. There is growth, but not the kind that has followed past recessions, when housing made a sizable contribution to the recovery. Instead, growth has been relatively anemic. The housing market remains troubled. Partly as a consequence of this, credit markets have not been strong and bank lending has been continually declining since the start of the economic crisis in 2008. Moreover, the troubles in Europe could have a negative impact on credit activity in the United States.

Despite these headwinds, American consumers continue to spend. This is a bit surprising given the various negative influences faced by U.S. consumers. Unemployment is uncomfortably high (above 8.5 percent), real disposable incomes have been declining over the past year and various measures of consumer confidence have recently been at near-historic lows. Yet consumer spending has been rising. There are various explanations. First, consumers have substantially paid down debt: debt service payments as a share of income are at the lowest levels since 1993, so consumer cash flow has improved. In addition, the increase in spending lately has been at the expense of saving. The saving rate has declined, suggesting a higher degree of confidence on the part of consumers despite what they tell survey takers. Finally, it is likely that there is considerable pent-up demand following a long dry period.

Consumers may feel a bit more confident because the overall economy is showing signs of renewed (albeit modest) strength. In the first half of 2011, economic growth was so anemic that many pundits worried that the United States was heading into a new recession. Today, fears of a double dip have abated somewhat as growth has accelerated. Industrial activity has been rising moderately, with particular focus on production of capital goods. In fact, business investment, especially in equipment and software, has been quite strong during the latter half of 2011.

In addition, exports have been strong. Although export growth has decelerated somewhat as the global economy has slowed, it remains strong and contributes substantially to overall GDP growth. This reflects the effects of a relatively weak dollar and the impact of a decade of sizable productivity gains for the manufacturing sector.

Finally, recent growth has been almost entirely due to increased demand for goods and services. There has been little inventory accumulation and inventories remain historically lean. This is good news, as it means that the increased output was entirely due to increased demand. It also bodes well for the future, as further increases in demand will require more production rather than dipping into existing inventories.

The impact of economic policy has been mixed. On the one hand, monetary policy remains supportive of growth. Although the Federal Reserve is no longer engaged in “quantitative easing,” it is engaged in a policy designed to reduce long-term interest rates and, therefore, stimulate more credit demand. While it is too early to say whether this has been effective, the decline in bank lending has eased and consumer willingness to take on new debt has increased. The Fed has indicated that it is open to another round of quantitative easing should the economy generate disappointing growth.

Fiscal policy is a different story. During 2011, the President and the Congress failed to reach an agreement on dealing with long-term budgetary issues. This resulted in the first-ever downgrade of the U.S. government’s credit worthiness. Although the bond market yawned at this news, it probably had a negative impact on business confidence, and it certainly had a negative impact on equity prices. If Congress does absolutely nothing, the budget deficit will decline considerably. That is because, under current law, taxes are scheduled to rise considerably at the end of 2012, yielding nearly $3 trillion over 10 years. In addition, there have already been $2.2 trillion in spending cuts built into future budgets. Thus, the real issue facing Congress is how to eliminate those tax increases and find offsetting reductions in future budget deficits.

For retailers, the U.S. economic environment is lukewarm. A reasonable expectation for the coming year is that consumer spending growth will be positive but modest, that inflation will be low, that consumers will remain relatively price sensitive and that commodity prices will be soft. It is also a reasonable assumption that, to the extent there are income gains, a disproportionate share will accrue to upper-income households. Thus, spending growth will be bifurcated.

Japan
Japan suffered grievously in 2011 due to the terrible earthquake and tsunami. Aside from the unspeakable human cost, there was a huge economic cost as well. The sharp drop in electricity production and the damage to the transport infrastructure led to a big decline in industrial output. Not only did this lead to a drop in Japan’s GDP, it had a global impact as well, as much of the global automotive and electronics industry supply chains are dependent on Japan’s participation. The outlook for 2012, however, is better. Industrial production has bounced back and, in the third quarter of 2011, the economy grew rapidly – especially due to the resumption of exports. In addition, the Parliament has allocated the equivalent of $240 billion to reconstruction, most of which will be spent in the next 18 months. Thus, this should have a positive impact on growth in 2012.

Still, Japan faces some negative influences. First, it is likely that the reconstruction spending will be financed in part by higher taxes on consumers, and this will probably have a negative impact on retailing. Second, Japan remains highly dependent on exports, yet the value of the yen is at an historic high and is not expected to come down. Moreover, as the global economy slows, export growth is likely to decelerate.

Finally, although Japan’s central bank has engaged in a more aggressive monetary policy, this alone may not be sufficient. The goal of such a policy is to increase inflation, reduce real interest rates and stimulate more spending and credit market activity. Yet as of this writing, inflation remains very low, consumer spending is anemic and credit market activity is poor. Absent a more aggressive policy, it is likely that Japan’s economy will grow slowly following the end of reconstruction spending.

India
Indian retailing briefly made global headlines when the government announced it had changed the rules regarding foreign investment so that multi-brand foreign retailers would be permitted to own up to 51 percent of an Indian retail enterprise. In the long-term, this would have a positive impact on economic growth and could lead to a rationalization of the supply chain, greater supply chain efficiency and greater effective spending power for consumers. It would also be beneficial to the world’s leading retailers as they continue to seek global opportunities beyond the Chinese market. Facing serious opposition, however, the government backed down and withdrew the planned liberalization. At this writing, it is not clear whether and when this proposal will be offered again.

In the short term, the outlook for India is a bit cloudy. The Indian economy is clearly slowing following a period in which monetary policy was tightened to fight inflation. The problem is that, although the monetary tightening resulted in slower economic growth, it did not bring inflation down. Now policymakers are faced with the conundrum of slow growth with persistent inflation.

That said, because trade is a modest share of GDP, India is relatively immune to the problems in the global economy. . In addition, India’s financial sector is not highly exposed to the troubles in European credit markets. Thus, even a worsening of the situation in Europe is not likely to have a big negative impact on India.

Longer term, India’s prospects are good. The country has a youthful population, which bodes well for growth and consumer spending. Economic policy has been supportive of growth through deregulation. In addition, India’s capital markets have funneled credit to entrepreneurs, contributing to growth. India does have obstacles, however. These include a high degree of trade protection, continuing regulation of labor markets and uncertainty regarding the future of policy.

Brazil
As in much of the emerging world, Brazil’s policymakers have quickly shifted from a focus on excessive inflation toward a focus on growth. In the first half of 2011, Brazil was growing rapidly and experiencing uncomfortably high inflation. The central bank raised interest rates, which resulted in a sharp rise in the value of the currency and harmed export competitiveness. Yet by the second half of the year, with domestic demand decelerating and exports being harmed by slower global growth, the central bank shifted and cut interest rates.

Brazil is likely to have modest growth and declining inflation in 2012. Interestingly, consumer spending has held up well despite the economic slowdown. This was due in part to continuing growth of consumer credit. While positive for spending, this credit expansion does pose a risk to the economy and especially to the banking system.

Longer term, the prospects for Brazil’s economy and consumer sector are very good. With a youthful population, favorable economic policies and sizable foreign direct investment, growth should be strong. In addition, roughly half of Brazil’s exports are now manufactured goods. This is a big change from the past, when Brazil was largely a commodity exporter, and it suggests a less volatile future. Improving income distribution and the rapid rise of the middle class also bode well for continued growth of modern retailing.

Russia
Russia’s growth has been moderately strong lately owing to the strength of commodity prices. In addition, there are indications of greater openness to foreign investment in the commodity sector, thereby offering the possibility of increased commodity production. Yet Russia’s continued dependence on commodities makes it vulnerable to volatile prices. Russia is also highly dependent on Western Europe, and a deepening crisis there would have a strong negative impact on Russia.

As long as the economy grows, Russia’s retail industry has good prospects, at least in the largest cities where a disproportionate share of spending power exists. On the other hand, a declining and aging population means that longer term prospects are not great. And a failure to diversify away from commodities puts the retail sector at the mercy of forces beyond the control of Russia’s authorities.

The Economic Situation for Retailers
The global economy is decelerating, with growth in 2012 likely to be slower than was experienced in 2011 in many of the world’s leading markets.

In Europe, the crisis of the euro has led to the tightening of credit markets. In an effort to rebuild investor confidence, governments across the continent are cutting spending and raising taxes, the net effect of which is to weaken economies and, in the process, further undermine confidence. Meanwhile, the European Central Bank engages in a relatively neutral monetary policy aimed at suppressing inflation. As of this writing, the risk remains that the Eurozone will crumble, leading to an even worse economic downturn.

In the United States there are signs of accelerating economic activity, yet the failure of the government to agree on a path toward fiscal rectitude has wreaked havoc with investor confidence, hurting equity prices and employment creation. While the U.S. economy may accelerate in 2012, it will probably not grow at a pace sufficient to significantly reduce unemployment.

The world’s second-largest economy, China, is slowing following a tightening of monetary policy combined with the negative effects of slow growth in Europe and the United States. In addition, the remaining BRICs face slower growth resulting from the lagged effects of tight monetary policy and weak global growth.

Only in Japan is economic growth in 2012 widely expected to exceed that of 2011. The reason is that 2011 was so awful following the devastating earthquake and tsunami, andreconstruction expenditures are likely to provide a temporary jolt to the Japanese economy.

Retailers may find some silver linings in this otherwise cloudy environment, however. One positive effect of slower global growth will be continued dampening of commodity prices. For retailers, this means some improvement on the cost side of the ledger. Meanwhile, a number of countries, including the United States, Japan, several in Western Europe and many leading emerging markets, are seeing higher retail price inflation. Combined with stagnant input prices, this suggests the possibility of improved profit margins, even in the context of slow top line growth.

In many of the slowing markets, a disproportionate share of the growth of consumer income is accruing to the relatively affluent. This is especially true in the United States and China. Hence, for retailers targeting upscale consumers, the environment might not be so bad. As for retailers targeting everyone else, the ability to offer low prices to uncertain consumers will be a clear competitive advantage.

The most significant silver lining can be found on the long-term horizon. Even though the economic environment in 2012 will be difficult, the long-term outlook for the global economy remains good. Global growth in the coming decade is expected to be strong, with particular strength coming from leading emerging markets other than China. Of course China will grow, but it faces some headwinds, both demographic and structural. Other emerging markets like India, Brazil, Turkey, Indonesia, the Andean region of South America and much of sub-Saharan Africa offer the possibility of stronger growth and new opportunities for the world’s leading retailers.

Let us now consider the outlook for the world’s leading retail markets:

Western Europe
It is difficult to provide a helpful roadmap to a situation that, as of Q4 2011, still seemed to be changing daily. So perhaps it is best to look back at how it came to this.

The Eurozone project was intended to bind the economic and political fortunes of Europe’s economies in perpetuity, yet the architecture of this union was always lacking. Countries were required to maintain fiscal discipline, but there was never a credible vehicle for ensuring it. The first countries to violate the rules were Germany and France, and it is not surprising that others soon followed. Indeed, the existence of the euro enabled the countries of Southern Europe to borrow with abandon. Investors were happy to extend credit at low interest rates with the expectation that bonds denominated in euros were a safe asset.

Still, the absence of fiscal rectitude alone was not the biggest problem. The biggest problem was that several Mediterranean economies lost their competitiveness. Over the past decade, their wages rose far faster than their productivity, with the result that it became less feasible for them to generate the strong export revenues needed to service their external debts. Normally, a country with a competitiveness problem will devalue its currency. However, because these countries no longer have their own currencies, they cannot restore competitiveness unless they dramatically accelerate productivity growth and/or cut wages – both tall orders.

When Greece was unable to roll over its considerable debts and the EU bailout was deemed insufficient to correct Europe’s ailments, investors became fearful. Governments faced difficulty in rolling over debts, and banks that held such debts faced problems raising funds. Risk spreads increased, credit market activity declined and Europe faced a new recession.

Following the summer of 2011, Europe’s governments agreed on various measures to calm markets, but to no avail. Banks agreed to take a haircut on Greek debt, enabling Greece to reduce its borrowing requirement. The banks were then required to raise capital, most likely by reducing lending and selling assets. The EU established a large fund to provide liquidity to troubled sovereign lenders. Intended as a confidence-building measure to assure investors that sovereign debt was safe, the fund failed to calm markets.

There are three possible scenarios as to what might happen next. In the first, Europe agrees to engage in greater integration in order to avoid disintegration. This could entail using the European Central Bank (ECB) to backstop sovereign debtors and create a fiscal union with large transfers of resources from richer to poorer nations within the union. This would enable the Eurozone to succeed and ultimately prosper. The problem with this scenario is that it requires individual countries to give up sovereignty and abide by conditions set by the richer countries in the EU.

The second scenario is that the Eurozone fails. While this could happen, the short-term costs of disintegration would be catastrophic. It can be argued that, in the long run, some of the troubled countries would be better off outside the Eurozone, but much of Europe would suffer grievously during the transition. The Mediterranean countries would face problems in gaining access to global credit markets, while the northern economies would see their currencies rise rapidly, thereby hurting exports.

The third scenario, then, seems to be the most likely: Europe manages to hold the Eurozone together but fails to take action that would guarantee its success. This could be called the “muddling along scenario” and would likely involve a prolonged period of slow economic growth, political turmoil and periodic crises.

What does this scenario mean for retailers? It means continued fiscal contraction across Europe, in part through higher taxes, and tight credit market conditions. Consumer spending would grow slowly, if at all. Consumers would be highly price sensitive and uncertain about the future. For retailers, it would mean a severe market share battle. It would also means that, for retailers that are financially healthy, there would be good reason to accelerate the process of globalization in order to find growth outside of Europe.

China
China’s economy is decelerating, the result of tighter monetary policy in 2011 and declining export growth. In response, China’s central bank has stopped tightening policy. Therefore, although China’s economy will slow in 2012, it will not necessarily slow dramatically. On the other hand, it is notable that a senior Chinese official recently predicted that growth in 2012 would be below 9 percent -- the first year since 2001 that it has done so. Interestingly, there is evidence that the economic slowdown is being experienced principally by small to medium-sized private businesses (especially those that export) and not by the large state-run enterprises that retain favorable access to credit.

China’s officials have complained about the rapid expansion of U.S. government debt. This reflects fear that the massive stock of foreign currency reserves held by China’s government could lose value. Less attention, however, has been paid to the big increase in overall debt in China itself. That is likely to change soon, given the fact that overall debt has nearly tripled in the past five years. Notably, a top Chinese official recently said that the debt of China’s local governments is “our version of the U.S. subprime crisis.” The $1.7 trillion in debts issued by local governments to fund infrastructure has been a concern for some time, but officials have downplayed the danger until now. The fear is that multiple defaults without a bailout from the central government could damage the health of China’s banks. How did this come about?

When the global economic crisis began in 2008 and China’s exports suddenly dropped, the government implemented a vast stimulus program to boost domestic demand and offset the decline in exports. Part of this involved extending credit to provincial and local governments to engage in infrastructure development. In the short run, this policy was successful in boosting growth and preventing a general recession. The problem, however, is that many such investments have failed to generate adequate returns. The Chinese government estimates that little more than one-quarter of local government investment has produced a return adequate to service the debts.

Local government borrowing is not the entire problem. During the global crisis, the government injected capital into state-run banks so that they could lend to state-run companies. The result was an investment boom, but too many of those investments are not producing an adequate return. As a result, investment in fixed assets surged, reaching almost 50 percent of GDP last year. Meanwhile, consumer spending declined to about 35 percent of GDP. Now that the Chinese economy is slowing, the risk exists that China’s debtors will soon face greater difficulties in servicing their debts.

So is China at risk of its own financial crisis? The answer is yes and no. There is a danger that a new round of defaults will damage the solvency of China’s state-run banking system, but it is likely that the government would bail out such banks and, thereby, prevent a larger financial crisis.

China does face a risk, however,. Specifically, if the government were compelled to bail out troubled financial institutions, it would probably not support continued lending for the purpose of poorly conceived investments. Consequently, investment would likely fall considerably. Given that investment is now close to 50 percent of GDP, such a fall could have serious consequences for GDP, absent an offsetting increase in something else. What could that something else be?

Exports are not likely to take up the slack. Instead, China will look toward a boost in consumer spending to offset a decline in investment. Given that consumer spending is now only 35 percent of GDP, it would have to grow very rapidly to make a difference and avoid a significant economic slowdown.

There are, however, some positive signs concerning the prospect for consumer spending. First, wages have been rising, adding to real disposable incomes. This reflects a shortage of labor, as demographic trends limit labor force growth and internal migration slows. In addition, provincial and local governments have been increasing their minimum wage. Second, the government intends to have state-run companies pay higher dividends to shareholders (mainly the government). This money could be used to boost overall spending. Third, high inflation might spur more spending by consumers. Fourth, the currency is gradually being allowed to rise in value. This reduces import prices and helps to stimulate consumer spending.

On the other hand, the biggest negative for consumer spending is simple demographics. Due to the lagged effect of China’s one child policy, the labor force is expected to grow much more slowly in the coming decade than it did during the past 10 years. As such, the prime consuming age cohort will barely grow while the elderly population will grow rapidly.

Finally, one side effect of China’s unbalanced economy is a sharp increase in income inequality. While incomes have increased overall, lower income cohorts have not seen significant increases in purchasing power, especially as home prices have increased dramatically. There are reasons to expect that China’s economy will grow more slowly in the coming decade. Although consumer spending is likely to increase as a share of GDP, it is not clear that it will be sufficient to create a consumer spending boom.

United States
As of this writing, the U.S. economy is showing signs of modest strength. There is growth, but not the kind that has followed past recessions, when housing made a sizable contribution to the recovery. Instead, growth has been relatively anemic. The housing market remains troubled. Partly as a consequence of this, credit markets have not been strong and bank lending has been continually declining since the start of the economic crisis in 2008. Moreover, the troubles in Europe could have a negative impact on credit activity in the United States.

Despite these headwinds, American consumers continue to spend. This is a bit surprising given the various negative influences faced by U.S. consumers. Unemployment is uncomfortably high (above 8.5 percent), real disposable incomes have been declining over the past year and various measures of consumer confidence have recently been at near-historic lows. Yet consumer spending has been rising. There are various explanations. First, consumers have substantially paid down debt: debt service payments as a share of income are at the lowest levels since 1993, so consumer cash flow has improved. In addition, the increase in spending lately has been at the expense of saving. The saving rate has declined, suggesting a higher degree of confidence on the part of consumers despite what they tell survey takers. Finally, it is likely that there is considerable pent-up demand following a long dry period.

Consumers may feel a bit more confident because the overall economy is showing signs of renewed (albeit modest) strength. In the first half of 2011, economic growth was so anemic that many pundits worried that the United States was heading into a new recession. Today, fears of a double dip have abated somewhat as growth has accelerated. Industrial activity has been rising moderately, with particular focus on production of capital goods. In fact, business investment, especially in equipment and software, has been quite strong during the latter half of 2011.

In addition, exports have been strong. Although export growth has decelerated somewhat as the global economy has slowed, it remains strong and contributes substantially to overall GDP growth. This reflects the effects of a relatively weak dollar and the impact of a decade of sizable productivity gains for the manufacturing sector.

Finally, recent growth has been almost entirely due to increased demand for goods and services. There has been little inventory accumulation and inventories remain historically lean. This is good news, as it means that the increased output was entirely due to increased demand. It also bodes well for the future, as further increases in demand will require more production rather than dipping into existing inventories.

The impact of economic policy has been mixed. On the one hand, monetary policy remains supportive of growth. Although the Federal Reserve is no longer engaged in “quantitative easing,” it is engaged in a policy designed to reduce long-term interest rates and, therefore, stimulate more credit demand. While it is too early to say whether this has been effective, the decline in bank lending has eased and consumer willingness to take on new debt has increased. The Fed has indicated that it is open to another round of quantitative easing should the economy generate disappointing growth.

Fiscal policy is a different story. During 2011, the President and the Congress failed to reach an agreement on dealing with long-term budgetary issues. This resulted in the first-ever downgrade of the U.S. government’s credit worthiness. Although the bond market yawned at this news, it probably had a negative impact on business confidence, and it certainly had a negative impact on equity prices. If Congress does absolutely nothing, the budget deficit will decline considerably. That is because, under current law, taxes are scheduled to rise considerably at the end of 2012, yielding nearly $3 trillion over 10 years. In addition, there have already been $2.2 trillion in spending cuts built into future budgets. Thus, the real issue facing Congress is how to eliminate those tax increases and find offsetting reductions in future budget deficits.

For retailers, the U.S. economic environment is lukewarm. A reasonable expectation for the coming year is that consumer spending growth will be positive but modest, that inflation will be low, that consumers will remain relatively price sensitive and that commodity prices will be soft. It is also a reasonable assumption that, to the extent there are income gains, a disproportionate share will accrue to upper-income households. Thus, spending growth will be bifurcated.

Japan
Japan suffered grievously in 2011 due to the terrible earthquake and tsunami. Aside from the unspeakable human cost, there was a huge economic cost as well. The sharp drop in electricity production and the damage to the transport infrastructure led to a big decline in industrial output. Not only did this lead to a drop in Japan’s GDP, it had a global impact as well, as much of the global automotive and electronics industry supply chains are dependent on Japan’s participation. The outlook for 2012, however, is better. Industrial production has bounced back and, in the third quarter of 2011, the economy grew rapidly – especially due to the resumption of exports. In addition, the Parliament has allocated the equivalent of $240 billion to reconstruction, most of which will be spent in the next 18 months. Thus, this should have a positive impact on growth in 2012.

Still, Japan faces some negative influences. First, it is likely that the reconstruction spending will be financed in part by higher taxes on consumers, and this will probably have a negative impact on retailing. Second, Japan remains highly dependent on exports, yet the value of the yen is at an historic high and is not expected to come down. Moreover, as the global economy slows, export growth is likely to decelerate.

Finally, although Japan’s central bank has engaged in a more aggressive monetary policy, this alone may not be sufficient. The goal of such a policy is to increase inflation, reduce real interest rates and stimulate more spending and credit market activity. Yet as of this writing, inflation remains very low, consumer spending is anemic and credit market activity is poor. Absent a more aggressive policy, it is likely that Japan’s economy will grow slowly following the end of reconstruction spending.

India
Indian retailing briefly made global headlines when the government announced it had changed the rules regarding foreign investment so that multi-brand foreign retailers would be permitted to own up to 51 percent of an Indian retail enterprise. In the long-term, this would have a positive impact on economic growth and could lead to a rationalization of the supply chain, greater supply chain efficiency and greater effective spending power for consumers. It would also be beneficial to the world’s leading retailers as they continue to seek global opportunities beyond the Chinese market. Facing serious opposition, however, the government backed down and withdrew the planned liberalization. At this writing, it is not clear whether and when this proposal will be offered again.

In the short term, the outlook for India is a bit cloudy. The Indian economy is clearly slowing following a period in which monetary policy was tightened to fight inflation. The problem is that, although the monetary tightening resulted in slower economic growth, it did not bring inflation down. Now policymakers are faced with the conundrum of slow growth with persistent inflation.

That said, because trade is a modest share of GDP, India is relatively immune to the problems in the global economy. . In addition, India’s financial sector is not highly exposed to the troubles in European credit markets. Thus, even a worsening of the situation in Europe is not likely to have a big negative impact on India.

Longer term, India’s prospects are good. The country has a youthful population, which bodes well for growth and consumer spending. Economic policy has been supportive of growth through deregulation. In addition, India’s capital markets have funneled credit to entrepreneurs, contributing to growth. India does have obstacles, however. These include a high degree of trade protection, continuing regulation of labor markets and uncertainty regarding the future of policy.

Brazil
As in much of the emerging world, Brazil’s policymakers have quickly shifted from a focus on excessive inflation toward a focus on growth. In the first half of 2011, Brazil was growing rapidly and experiencing uncomfortably high inflation. The central bank raised interest rates, which resulted in a sharp rise in the value of the currency and harmed export competitiveness. Yet by the second half of the year, with domestic demand decelerating and exports being harmed by slower global growth, the central bank shifted and cut interest rates.

Brazil is likely to have modest growth and declining inflation in 2012. Interestingly, consumer spending has held up well despite the economic slowdown. This was due in part to continuing growth of consumer credit. While positive for spending, this credit expansion does pose a risk to the economy and especially to the banking system.

Longer term, the prospects for Brazil’s economy and consumer sector are very good. With a youthful population, favorable economic policies and sizable foreign direct investment, growth should be strong. In addition, roughly half of Brazil’s exports are now manufactured goods. This is a big change from the past, when Brazil was largely a commodity exporter, and it suggests a less volatile future. Improving income distribution and the rapid rise of the middle class also bode well for continued growth of modern retailing.

Russia
Russia’s growth has been moderately strong lately owing to the strength of commodity prices. In addition, there are indications of greater openness to foreign investment in the commodity sector, thereby offering the possibility of increased commodity production. Yet Russia’s continued dependence on commodities makes it vulnerable to volatile prices. Russia is also highly dependent on Western Europe, and a deepening crisis there would have a strong negative impact on Russia.

As long as the economy grows, Russia’s retail industry has good prospects, at least in the largest cities where a disproportionate share of spending power exists. On the other hand, a declining and aging population means that longer term prospects are not great. And a failure to diversify away from commodities puts the retail sector at the mercy of forces beyond the control of Russia’s authorities.